Using index funds without investing in them

By Markdale Funds 0 Comments

Some investors will keep actively managing their investment portfolio no matter how much data suggests they should not. Because, it doesn’t matter what the data says. It matters how we feel. If it makes us feel good to pick a winning stock, or we feel like we can outperform. Its very difficult to change our minds once we believe in something.

But, even when you’re an active investment manager, there are still many ways to use index funds (without investing in them).

This post will begin by describing the difference between active vs passive investing. Then, we will use the S&P 500 to illustrate how indexes work in practice. Finally, we will explain how active investors can use index funds to improve their portfolio in the following ways:

Benchmarking
Portfolio Construction
Screening

What is active management?

Active investing is an investment strategy that involves making specific investment decisions with the goal of outperforming a benchmark index. Active investors typically buy and sell securities, based on their analysis of market trends, economic data, company financial statements, and other factors. They may also use strategies such as stock picking, sector rotation, or market timing to try to beat the market average.

Active investors believe that they can generate better returns than the market by identifying undervalued or overvalued securities, exploiting market inefficiencies, and taking advantage of short-term trends. However, active investing involves higher fees and higher turnover than passive investing, and it also requires more time and effort to conduct research and analysis of individual securities.

What is passive investing?

Passive investing is an investment strategy that involves simply tracking a benchmark average rather than trying to beat it. Passive investors typically use index funds and exchange-traded funds (ETFs) to gain exposure to a broad market index such as the S&P 500, without attempting to select individual stocks or time the market.

The goal of passive investing is to achieve a similar return to the overall market or benchmark index, with lower fees and lower turnover than active investing. Passive investors believe that trying to beat the market is statistically unlikely and often not worth the extra costs and risks involved. By investing in a diversified portfolio of securities that match a benchmark index, they can achieve broad market exposure and reduce the risks associated with individual stock picking.

It turns out that passive investing outperforms active investing most of the time. This fact alone should encourage more active managers to re-consider their approach (or level of fees).

What are differences between active and passive investing?

The key difference between active and passive investing is that active investing involves trying to outperform the market by making specific investment decisions, while passive investing involves simply tracking the market by investing in a diversified portfolio of securities that match a benchmark index.

How do the returns from active vs passive investing compare?

Decades of data confirm that passive investments beat their active peers 80% of the time. This means that in the long-run, you have a better chance of superior returns using index funds than by either picking stocks for yourself or by using an investment professional to choose stocks on your behalf.

What is the S&P 500?

The S&P 500 index is a market capitalization-weighted index of 500 large publicly traded companies in the United States. The index is widely considered to be one of the best representations of the U.S. stock market and is a commonly used to benchmark passive portfolios.

The S&P 500 was first introduced in 1957 and has since become one of the most widely followed stock market indexes in the world. It is managed by S&P Dow Jones Indices, a division of S&P Global, and is widely used as a measure of the overall health of the U.S. economy.

The 500 companies that make up the S&P 500 index are selected based on certain criteria, such as market capitalization, liquidity, and industry sector. The index is then constructed by weighting each stock in the index by its market capitalization, with the largest companies having the highest weighting in the index. Basically, the 500 stocks that make up the S&P 500 are the 500 largest
American companies traded publicly.

The S&P 500 index covers a broad range of industries, including technology, healthcare, financials, and consumer goods, among others. Because of its broad diversification, the index is often used as a proxy for the overall performance of the U.S. stock market.

The S&P 500 is widely regarded as a reliable measure of long-term stock market performance, with an average annualized return of approximately 10% over the past several decades. It is also frequently used as a benchmark for mutual funds and other investment products, as well as for evaluating the performance of individual stocks or sectors.

So, what are index funds?

Index funds are a type of mutual fund or exchange-traded fund (ETF) that is designed to track the performance of a specific market index, such as the S&P 500 or the NASDAQ. Rather than trying to beat the market, index funds seek to match the performance of the underlying index by holding a diversified portfolio of securities that closely resemble the index.

The securities held in an index fund are determined by the composition of the underlying index, which may be based on factors such as market capitalization, industry sector, or geographic region. For example, an S&P 500 index fund will typically hold a portfolio of the 500 largest publicly traded companies in the United States, held in proportions according to their market capitalization.

Because index funds do not require active management or individual stock selection, they typically have much lower fees and lower turnover than actively managed funds. This can make them an attractive option for investors who want broad market exposure and low costs, and who do not want to take on the risks associated with individual stock picking.

Index funds are also highly transparent, as their holdings are publicly disclosed on a regular basis. This makes it easy for investors to track the performance of their funds and to compare them to other funds or market benchmarks.

Without investing in passive benchmarks, you can still use index funds to help your own portfolio. Here are three ways:

Benchmarking
Portfolio Construction
Screening

Benchmarking

What does “benchmarking” investment performance mean?

Benchmarking investment performance means measuring the performance of an investment portfolio or fund against a selected benchmark. The benchmark is a standard against which the investment’s performance is compared to determine how well it is doing relative to the broader market or a specific investment category.

The benchmark could be a market index, such as the S&P 500, or a specific category index, such as the MSCI World Small Cap Index. It could also be a custom benchmark created by the investor or investment manager that reflects the investor’s specific investment objectives and constraints.

The purpose of benchmarking investment performance is to evaluate the performance of the investment portfolio or fund against a relevant standard, so that investors can determine whether their investment is meeting their expectations and objectives. By comparing the investment’s returns to the benchmark, investors can assess the investment’s risk-adjusted returns, volatility, and other performance metrics.

If the investment portfolio or fund outperforms the benchmark, it indicates that the investment strategy has been successful. If it underperforms the benchmark, it may suggest that the investment strategy needs to be re-evaluated or adjusted.

How are ETFs used by investors to benchmark their returns?

Measuring portfolio performance against a benchmark that consists of an ETF or a portfolio of ETFs that matches an asset allocation helpful. When measuring returns, the benchmarks chosen must be investible. This means they must not be hypothetical investments you could have made, but real-world alternatives.

The market prices and returns of ETFs are readily available to any investor. Their prices are transparent, and the way returns are achieved are easy to understand. This includes disclosing which holdings make up each ETF. These reasons make using ETFs as benchmarks for your portfolio ideal.

Deconstruction

Considering the holdings of each index ETF is publicly available to investors of the ETF’s website, can this information be used to mimic returns?

Yes, the holdings of each index ETF are publicly available on the ETF’s website and can be used by investors to mimic returns. By analyzing the ETF’s holdings, an investor can gain insight into the ETF’s exposure to specific sectors, asset classes, and individual stocks. They can then use this information to construct a portfolio of individual stocks that replicates the ETF’s exposure.

If an investor deconstructed an ETF to create their own portfolio with the same objectives, what are the pros and cons of this approach?

There are pros and cons to deconstructing an ETF to create a portfolio with the same objectives. Here are a few to consider:

Pros:

Customization: An investor who deconstructs an ETF can create a portfolio that is tailored to their specific investment objectives, risk tolerance, and preferences. They can choose the specific stocks, bonds, or other assets that they want to include in their portfolio, rather than being limited to the holdings of the ETF.
Lower expenses: While ETFs are typically lower-cost than actively managed mutual funds, an investor who deconstructs an ETF can potentially reduce their expenses even further by avoiding the ETF’s management fees and trading costs.
Tax efficiency: By purchasing individual stocks or bonds, an investor can potentially manage their tax liability more efficiently than if they held the ETF, as they can selectively harvest losses, minimize capital gains, and control the timing of transactions.

Cons:

Time and effort: Deconstructing an ETF and constructing a portfolio of individual securities can be time-consuming and require significant effort on the part of the investor. The investor will need to research and select individual securities, monitor their performance, and periodically adjust their portfolio as needed.
Lack of diversification: An ETF is typically designed to provide broad exposure to an asset class, sector, or region, which can help to provide diversification and reduce risk. If an investor deconstructs the ETF and only holds a few individual securities, they may be more exposed to specific risks associated with those securities, such as company-specific or industry-specific risks.
Potential higher transaction costs: Deconstructing an ETF can involve buying and selling many individual securities, which can result in higher transaction costs than just buying and holding the ETF.

How often do index funds re-balance their portfolios? Is this a good reason to use an ETF instead of constructing a portfolio using an ETFs publicly available information?

The frequency with which index funds re-balance their portfolios can vary depending on the fund’s specific strategy and the index it is tracking. Generally, most index funds will re-balance their portfolios on a regular schedule, such as quarterly or annually, to ensure that the fund’s holdings continue to reflect the underlying index.

Whether or not this is a good reason to use an ETF instead of constructing a portfolio using an ETF’s publicly available information depends on the investor’s individual needs and preferences. If an investor wants to closely track a specific index, an ETF can provide an easy and convenient way to do so, as the investor can simply buy and hold the ETF, without needing to worry about the ongoing re-balancing of the underlying portfolio.

On the other hand, if an investor is comfortable with actively managing their portfolio and wants to have greater control over their holdings, they may prefer to deconstruct an ETF and create their own portfolio using the publicly available information. This approach can allow the investor to customize their portfolio to their specific preferences, and potentially reduce expenses and increase tax efficiency.

Screening

Stock screening is a process of using specific criteria to identify and narrow down a list of stocks that meet certain requirements or characteristics. It is a tool commonly used by investors to help them identify potential investment opportunities and filter out stocks that don’t meet their investment objectives.

The screening process involves specifying a set of parameters or filters, such as market capitalization, price-to-earnings ratio, dividend yield, or other financial ratios, that are used to select stocks that fit an investment strategy or goal. For example, an investor may use stock screening to identify stocks that have a history of stable earnings growth, strong balance sheets, and low levels of debt.

Is examining the holdings of index ETFs a good way to generate investment ideas? How might investors do this in practice?

Examining the holdings of index ETFs can be a good way for investors to generate investment ideas, as it can provide insight into which companies or sectors are currently receiving market attention and investment. This approach is often used by investors who want to follow an investment strategy, such as sector investing or value investing.

To do this in practice, investors can start by researching and selecting an ETF that tracks an index or sector of interest. The investor can then review the ETF’s holdings and use this information to identify potential investment opportunities. For example, if an investor is interested in the healthcare sector, they might review the holdings of an ETF that tracks a healthcare index, such as the Health Care Select Sector SPDR Fund (XLV).

By reviewing the holdings of the XLV, the investor can see which companies are included in the ETF and use this information to identify potential investment opportunities in the healthcare sector. They can then conduct further research and analysis on these individual stocks to determine whether they meet their investment criteria.

Using index funds without investing in them